The financial world is realising blockchain is about infrastructure, not cryptocurrencies, and fund actors are adopting the technology to manage data across the industry ecosystem, according to our blockchain panellists.
Daniel Coheur, co-founder and chief commercial officer at Tokeny
Benjamin Dean, director, digital assets at WisdomTree
Jack White, vice president, data, digital & innovation at Citi Securities Services
Moderator: Nicholas Pratt, Funds Europe
FundsTech: Will blockchain be irrelevant in two or three years' time? Will another technology overtake it?
Jack White, Citi: No, I do not see blockchain becoming irrelevant anytime soon, but rather expect blockchain and distributed ledger technology (DLT) to become a major component of the regulated market infrastructure in the years to come. However, to get there, the industry needs acceleration in terms of regulatory clarity and making sure the appropriate risk management and controls are in place.
The adoption by financial services organisations at scale could happen, but it will be a gradual and phased approach rather than a ‘big bang’. There will also be certain markets, asset classes and processes that will not be appropriate for DLT.
Daniel Coheur, Tokeny: It’s been said that every new technology comes with a number of shortcomings, and it's just a matter of time before those shortcomings are fixed. For example, what made the mobile phone unique was not the ability to make calls but that a camera was attached. And what makes blockchain unique is trust in a sector where infrastructure is built to be as secure as possible rather than to facilitate the transfer of securities and assets. It will be a major benefit to the ecosystem to remove all of those intermediaries that are creating inefficiencies and adding cost and time.
The financial world is realising blockchain is an infrastructure play, not a crypto play. Crypto is just an application sitting on top of the network. There was this debate in the beginning about public and private blockchains - but we are seeing more convergence and innovation from the public blockchains. There’s no barrier to entry in terms of knowledge. The most successful blockchain network at the moment is India-based Polygon and with the number of coders you have in India, we’re going to see huge numbers of applications in the future. So, you need to create a bridge between public and private blockchains.
"The financial world is realising blockchain is an infrastructure play not a crypto play. Crypto is just an application sitting on top of the network."
What has been important over the last two years is the involvement of regulators which is an indication that this technology will be the future of the industry. Regulators are not the most reactive to innovation. They prefer to wait and see. But in Europe, with MiCA and the DLT Pilot Regime, the regulators understand this technology is transformative and therefore, they need to provide a regulatory framework as soon as possible to protect investors.
Benjamin Dean, WisdomTree: If we accept the idea that a blockchain is a series of technologies – open source software, distributed database, public key cryptography – bundled together, they are unlikely to all go away. The Bitcoin network, for example, was the first blockchain using these bundled technologies, and it has been around for 15 years. Not a short amount of time.
So where are we now? We’re probably at the early majority stage of the adoption curve. We wouldn’t be having this discussion today if we weren’t at that point, and the level of public awareness and use of these networks is much greater than it was just a few years ago. There’s still a lot more left to go, though. We’re nowhere near full saturation of the addressable market in the same way that, for comparison, there are now more smartphones than toothbrushes worldwide.
There’s a lot more that needs to be done to increase adoption. However, these are complicated technologies on the back end. To encourage adoption, you need to remove the complexity via an intuitive user interface that anyone can use.
In terms of something that might overtake it, thinking as a practitioner rather than an end-user, I would need to see something with more security, reliability, scalability and speed from the technology infrastructure.
FundsTech: Have you seen anything that you would describe as a breakthrough in terms of the blockchain, or has the development been more gradual than that?
Dean: Zero-knowledge rollups – or ‘zk rollups’ - and proofs have advanced much faster than anybody anticipated. This has meant that scalability on some networks is now potentially orders of magnitude larger or higher than it was envisioned to be just a few years ago.
There is also another element that’s related to zero-knowledge proofs which has privacy implications. Zero-knowledge proofs essentially mean that you’re able to interrogate a question to see if something’s true without knowing what the precise answer is from the person who holds that secret. If we’re able to square the circle, which is to have open networks with data that anyone can access and verify without actually having to have access to the underlying data, that potentially opens a whole series of use-cases that just weren’t technically possible just a few years ago.
White: From a technology perspective, I have not seen one specific eureka moment in the last two years. Instead, there has been a coalescence of several factors that are going to be required for regulated financial institutions to engage with blockchains in a safe, secure and compliant way. For example, we have seen the emergence of securities token standards and embedded permissioning and whitelisting, the maturity and proliferation of quantum safe private key management and the broader adoption of multi-party computation.
FundsTech: Is there any danger that we're using the technology to slightly refine an existing model rather than creating a new model?
White: There will be a natural evolution towards a degree of convergence of the ecosystems. From a regulatory and legal perspective, the traditional world is more mature. I would expect the emerging digital space to align more closely with the traditional model in terms of regulation and oversight in the future.
Coheur: To return to the mobile phone analogy, before the emergence of the GSMA standard, there were interoperability issues. You couldn’t send an SMS, and there were data roaming restrictions. And when the standard was developed on a global scale, the adoption of mobile phones grew to where we are today. That is what we were missing with the blockchain – a standard to represent digital assets on a public blockchain. Tokeny has been developing the ERC 3643 standard for the last five years now and we have made it open source to include crypto custodians, blockchain networks and asset managers. That is important because it helps to create regulatory and technology guidance and enables the industry to develop other applications.
FundsTech: Are increased awareness of cyber security and trust issues in a digital world the biggest driving force for the adoption of blockchain?
Coheur: If you develop a standard, you are removing all of those risks by allowing the security token to be permissioned. The standard is based on identity, so if you prove your identity, you have access to your assets. It is very important to understand that there is a means to provide such a level of security to those assets. So, the function of a digital wallet is not so much to guarantee the safety of the asset but to enable you to assign transactions that are generated on the network. The security is guaranteed by the protocol itself, which is based on identity.
The development of blockchain technology and services has definitely attracted attention from the regulator and has encouraged them to provide guidance if not new regulation. And that is a good thing. The idea is to allow people to operate in an environment where they and their compliance officers will feel comfortable. But let's not confuse what we do with securities and what's happening with cryptocurrencies, which is a very different world that is operating on non-permission blockchain with non-permission tokens where if you are hacked, you have a problem. But that is not what we are doing.
Dean: Cybersecurity is a complicated field. Typically, cyber security people look at three attributes: confidentiality, availability and integrity of data and systems. What's nice about these blockchain networks is, by virtue of the fact that they're open source, anyone can read the code. Anyone can plug into them. It means you don't have to build your own infrastructure and defend it.
"These networks come with their own cybersecurity challenges that a lot of people in traditional asset management and financial services might not be fully versed in. One element is key management and protecting private keys, which is a difficult task."
And when you've got networks - Bitcoin and Ethereum networks that operate at scale in terms of their consensus mechanisms - they're extremely hard networks to take down. So, you get the kind of availability benefits from these open networks that would be very hard to replicate if one were to build one’s own network and try and defend it.
On the other hand, these networks come with their own cybersecurity challenges that a lot of people in traditional asset management and financial services might not be fully versed in. One element is key management and protecting private keys, which is a difficult task. The good news is that we've got all kinds of vendors now that will provide those services.
The second element is around bugs, not usually at the protocol layer but mostly at the application layer. You sometimes hear about smart contracts being ‘hacked’. What's usually happened there is that somebody's introduced a bug into the contract software or code that has been exploited, and that can be very costly.
You solve a few security challenges by using open architecture, but at the same time, you create new cybersecurity headaches for yourself. And if you don't know how to manage them, it can be difficult to achieve the level of trust that some people require in order to run services using this technology.
FundsTech: Is this something that can be done by an existing team, or does it require new recruits?
Dean: I’m someone who spent a decade in cybersecurity before coming to asset management, and so from where I sit, I see asset management’s increasing need for the same skills that one used to have as a cybersecurity professional. For example, key management and code auditing.
If there was a set of ten skills a cybersecurity professional would have, maybe two to three of them would end up becoming more important than the rest for a blockchain technology implementation. It’s broadly the same cybersecurity skills as before, but some of them are more valuable and useful now for blockchains. Cybersecurity people don’t grow on trees, unfortunately; we’ve had a shortage of them for a long time, and it really comes back to bite if you don’t manage this stuff.
White: Cybersecurity on the blockchain comes down to two main areas of focus. First, there is embedding the security at a code level within the blockchain networks, whether that’s through permissioning or identity solutions like Daniel mentioned earlier. Understanding and being able to audit these solutions is really important. At Citi, we have established a DLT Centre of Excellence, and it is their role to understand these networks and protocols and how they could be used in a safe and sound manner.
On the other side of that point is physical security. The protection of private keys is obviously of great concern, and we see that as potentially analogous to the traditional role of a custodian or safekeeper of assets. These are the organisations that have implemented good governance, overall risk management and enterprise control environments. Citi’s Cyber team has invested significantly in building our capabilities for both digital and traditional solutions to protect from cyberattacks.
FundsTech: Is the launch of ESMA’s DLT pilot regime a significant development?
White: Providers can do some interesting things within these pilot regimes and proof of concepts. However, it’s important to understand what the exit path is for entry into the mainstream. That will be key to moving forward.
Dean: The nice thing about these kinds of pilot regimes and sandboxes is that people are recognising that this activity is happening and that there’s some potential benefit from it, and they have space to experiment. There’s a certain implicit acceptance and willingness to help cultivate what might be nice opportunities in the future.
At the same time, those activities are going to happen anyway; that’s one of the things that characterise this space, as there are a whole lot of open-source developers who, if they weren’t doing this professionally, would be doing it for recreation, they enjoy doing it so much!
It is good to see tacit acknowledgement and acceptance that this activity is happening.
Coheur: The DLT Pilot Regime regulation is amazing in a way because it’s paving the way towards real-time settlement. If you look at the two directives [MiCA and the DLT Pilot Regime], MiCA defined digital assets as a security. Therefore, if your security is represented on a chain, you don’t need new regulations, you just need to enforce the existing ones. #
The DLT pilot regime highlights the fact this is a new infrastructure that, through the use of smart contracts, enables you to settle a transaction on a blockchain in real time. And if you use a smart contract, then you don’t need an intermediary like a CSD [central securities depositary] anymore because the counterparty risk will be managed by the smart contract. Obviously, to say that you no longer need Euroclear and Clearstream is massively impacting for the industry and potentially transformative. And that’s why you need a sandbox to demonstrate that the technology is secure enough to enable that transformation.
FundsTech: What barriers have we seen in terms of blockchain adoption and development?
Dean: Usability. The reality is this is complex technology, and if you get things wrong, then bad things can happen. There is a clear need to be extremely thorough and conduct the necessary risk management due diligence, and this applies to all industries seeking to leverage the technology.
If there’s anything that I’d point to, it’s the speed at which the space evolves. In traditional financial services or fund management, you’re thinking about the next two to five years, what you could build with this technology and how you might be able to generate value from it for your own organisation or your clients. The issue is that in two to five years, the technology landscape’s completely different. It’s hard to anticipate, and as a consequence, you might go and build something that you think is future-proofed, and then you turn around in 18 months, and something’s fundamentally changed that now you’re a bit too far down the path to take advantage of.
It’s the speed of the change and evolution in this space which creates a whole lot of opportunities, but they can be tricky ones to seize. The emergence of standards is actually a very helpful element. If we had asked this question five years ago, we would have been talking about ERC20 fungible tokens and ERC721 non-fungible tokens. These are standards that emerged somewhat organically, and now they’re in place, people are able to build things at scale that are interoperable and “speak to one another”.
It’s really positive that we’re seeing a lot of standards emerge.
Coheur: I totally agree with the usability. For someone to assign a transaction from a digital wallet, they will first need to know the network on which the token has been published. Then when they think that everything is done, they will need to understand how much they have to pay in order for the transaction to be processed. It is far too complex.
Making another analogy, we saw the adoption of the internet happening at scale once we had the first browser that made this surfing experience as easy as possible. Similarly, when we started using email without having to indicate the server address while configuring our email.
"A lot of fund administrators and distributors are adopting blockchain technology to manage data across that disparate ecosystem of actors that operate in the funds’ world. I expect that adoption will increase, aside from the tokenisation piece."
The next step is to completely remove this complexity by hiding it. Otherwise, there will be no mass adoption because the technology is a barrier to entry.
But there are large investor-services firms looking to use the blockchain. Some have said publicly that they want to put thousands of funds on the blockchain in the next two years. This is one of the biggest things to happen in the last 12 months. But there is an infrastructure play that needs to happen before those providers can offer anything innovative. At the moment, there is no common data layer so information has to be entered multiple times.
White: A potential barrier that comes up in many client conversations and general industry commentary is the fragmentation of the ecosystem. It plays into the usability argument because a solution for one blockchain isn’t necessarily going to work for another. It is a concern, especially in relation to Benjamin’s point about the moving goalposts. If you build something now, is it still going to be the right solution for you in two, three or four years’ time? The fragmentation and churn that’s happening in terms of the favoured blockchain ecosystems and solutions emphasise and amplify that concern.
This is where there’s potential for traditional regulated service organisations to come in and really try and deliver that normalisation for clients across those different networks in the same way that they do for traditional financial networks now. Applying that expertise, experience and approach to these fragmented emerging digital ecosystems could be valuable in the future.
In terms of where we’re seeing blockchain being used in the funds industry, there are numerous pilots and proof-of-concepts, but they are not yet all operating at scale. That will be the challenge in years to come.
Aside from the cryptographically secured representations of assets, which is really what tokens are, we’re seeing a lot of use of blockchain from a pure data transmission perspective. It is one of the mature use cases. A lot of fund administrators and distributors are adopting blockchain technology to manage data across that disparate ecosystem of actors that operate in the funds’ world. I expect that adoption will increase, aside from the tokenisation piece.
FundsTech: In terms of addressing the fragmentation problem, is one of the potential barriers on a practitioner side that if you’re going to use blockchain to create a utility-like offering, then you need everybody on that same version of that blockchain?
White: Achieving the network effect is the holy grail of any utility, ecosystem or network. It’s going to be extremely challenging and unlikely for one particular blockchain or network to be triumphant and dominate. Being able to access and bridge between these fragmented networks and provide a normalised interface to users, whether it’s financial institutions or individuals, is going to be extremely powerful in achieving that network effect.
FundsTech: Is there also a danger that we’re adding another intermediary to help create a kind of utility, or is that inevitable in these formative stages?
White: I’d just draw the analogy back to the traditional world and the role a network bank plays in the traditional ecosystem. There are pools of assets and liquidity that are distributed across the world on a jurisdictional basis, and those organisations provide access to them in a normalised manner. I don’t think it’s an additional layer but rather a potential expansion of an existing role.
Coheur: People have to understand that there is no native interoperability between networks. If you use Polygon to publish your cap table, you need to scan this blockchain in order to have an overview of your transactions and, therefore, your cap table. If you publish your cap table on multiple chains, you need to scan each individual chain and then reconstruct the data in a single environment. This is creating inefficiencies.
The technology is very new, so whether there will be one blockchain or multiple blockchains is very hard to say. Maybe there will be a blockchain per type of activity but doing that on multiple chains will create a level of inefficiencies that are not suitable for what we are trying to achieve. Again, I don’t have a crystal ball, but if you understand the technology, you realise that those inefficiencies definitely not supporting the whole concept of what we are trying to achieve here.
Dean: The Ethereum Virtual Machine (EVM) compatibility has helped solve some of the issues that have been mentioned around fragmentation. A few years ago, while it was possible it hadn’t really emerged as a de facto standard, but now that it has, it’s simplified things. You don’t have to make as big a bet as you might have had to five years ago about which network will reach scale. Because of that EVM compatibility, you’re able to operate across different networks without having to recreate your code base over and over and over again. It’s promising in that respect because, indeed, fragmentation in the past has been a challenge, but fortunately, we see some solutions emerging.